The domino that never falls

The long-term prognosis for the debt-ridden economy is not good

WHAT do bond investors do when debt crises threaten the euro zone and America? Head for safety in a far more indebted country. Yields on Japanese government bonds (JGBs) fell to an eight-month low on July 19th; the yen strengthened against the euro and the dollar.

That looks very odd. Compared with Italy, the latest target of creditor angst, on many counts Japan is more troubling. Its net debt is bigger as a share of GDP and it has a primary budget deficit (ie, before interest payments), whereas Italy has a surplus. With the fastest-ageing society on Earth its growth prospects are not obviously better than Italy's, and its government is just as dysfunctional, if not as lurid. Even its free-floating currency is a mixed blessing: the yen has continued to strengthen after the March 11th earthquake and tsunami deepened Japan's recession.

The economy is now showing signs of recovery. But recent policy setbacks have thrown further doubt on the country's long-term creditworthiness. On July 19th the IMF gave a tepid welcome to a government plan, unveiled last month, to double the consumption tax to 10% by the mid-2010s, and called for something more ambitious. Ratings agencies did not hide their disappointment with the plan, which was watered down at the last minute.

Energy is another concern. In response to the meltdowns at the Fukushima nuclear-power plant, much of the country's nuclear capacity has been suspended. Naoto Kan, the prime minister, has talked of abandoning atomic energy altogether. It is hard to fathom what the government really intends to do but economists reckon a phase-out of all nuclear power would make projected economic growth even weaker and hit the trade balance, which has already slid into deficit (see chart).

The current account is still likely to remain in surplus because income from Japan's trove of foreign assets provides a bigger contribution than trade. But an energy crisis could encourage firms to reinvest their overseas profits rather than repatriating them, which could eventually eliminate the surplus. Once that happens, Japan would need to rely on foreign creditors.

Besides the current-account surplus, the main pillars of support for Japan's debt load are its cash-rich households and firms. Households alone have assets of ¥1,470 trillion ($16 trillion), or roughly twice the amount of outstanding government bonds. The corporate sector saves about 8% of GDP, which largely offsets a fiscal deficit that is expected to reach a whopping 10.5% of GDP this year. Much of this money is parked in Japanese financial institutions, which hold about three-quarters of government bonds. Foreigners, mainly central banks, account for just 5%.

With a strengthening currency and domestic deflation, holding JGBs has been a good bet even with ten-year yields down at nearly 1%. But the risks of a confidence crisis, though not necessarily imminent, cannot be ruled out. Banks, for example, hold JGBs because they cannot find better returns elsewhere. “It's not a matter of loyalty. They are trying to maintain their profits,” says Tab Bowers of McKinsey, a consultancy. When the risks of holding too much debt outweigh the rewards, they would jump ship as fast as anyone.